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Behavioural finance: the role of psychological factors in financial decisions

Gulnur Muradoglu
Cass Business School, London, UK, and

Nigel Harvey
University College London, London, UK
Abstract
Purpose The purpose of this paper is to introduce the special issue of Review of Behavioural Finance entitled Behavioural finance: the role of psychological factors in financial decisions. Design/methodology/approach The authors present a brief outline of the origins of behavioural economics; discuss the role that experimental and survey methods play in the study of financial behaviour; summarise the contributions made by the papers in the issue and consider their implications; and assess why research in behavioural finance is important for finance researchers and practitioners. Findings The primary input to behavioural finance has been from experimental psychology. Methods developed within sociology such as surveys, interviews, participant observation, focus groups have not had the same degree of influence. Typically, these methods are even more expensive than experimental ones and so costs of using them may be one reason for their lack of impact. However, it is also possible that the training of finance academics leads them to prefer methodologies that permit greater control and a clearer causal interpretation. Originality/value The paper shows that interdisciplinary research is becoming more widespread and it is likely that greater collaboration between finance and sociology will develop in the future. Keywords Decision making, Psychology, Behavioural finance, Research work Paper type Research paper

Review of Behavioral Finance Vol. 4 No. 2, 2012 pp. 68-80 r Emerald Group Publishing Limited 1940-5979 DOI 10.1108/19405971211284862

1. Introduction According to Glaser et al. (2004, p. 527): Behavioural finance as a subdiscipline of behavioral economics is finance incorporating findings from psychology and sociology into its theories. Behavioral finance models are usually developed to explain investor behaviour or market anomalies when rational models provide no sufficient explanations. Modern economics assumes that people choose between alternatives in a rational manner (von Neumann and Morgenstern, 1944) and that they know the probability distribution of future states of the world (Arrow and DeBreu, 1954). Modern finance assumes that markets are efficient and that agents know the probability distribution of future market risk (Markowitz, 1952; Merton, 1969). Research has been geared towards searching for a better risk factor/pricing model. In parallel with these theoretical developments, psychologists studying decision making were collecting data that suggested that individuals do not always make decisions in an optimal manner that those working in finance and economics assumed (e.g. Edwards, 1954, 1955). After a large corpus of data had accumulated, Bell et al. (1988) argued that it is worth making a conceptual distinction between normative

models of decision making that identified optimal ways of making decisions, descriptive models that identified how people actually make decisions under different conditions, and prescriptive models that identified ways of improving decision making when no normative models were available. They argued that economists may have been unwise to assume that normative models are descriptive. For many years, this behavioural research had little impact on economics. Behavioural economics did not exist. Kahneman (2011) argues that it originated in the early 1970s when Richard Thaler, then a graduate student in economics, demonstrated that one of his professors was highly susceptible to the cognitive bias that is now known as the endowment effect. Arguably, behavioural economics came of age when Kahneman and Tversky (1979) published prospect theory and matured after Kahnemans receipt of the Nobel Prize for Economics in 2002 demonstrated that economists considered behavioural research as worthy of inclusion in their field of study. Although Slovic (1972) drew the attention of those working within finance to the relevance of research on behavioural decision making to their concerns, behavioural finance was slower to develop than behavioural economics. The work of De Bondt and Thaler (1985, 1987) can be seen as a landmark that triggered expansion of the field. Later, Thaler (1999) went on to argue that research in the area would soon come to an end because financiers would be so convinced by the behavioural findings that they would adopt reasonable assumptions. However, although those working in finance may be more sympathetic to the notion of basing their theories on realistic assumptions than those working in other areas of economics, there is, as yet, little sign that the field is contracting. Good reviews on the development of the field of behavioural finance include those rling et al. (2009). by De Bondt et al. (2010), Daniel et al. (2002), Glaser et al. (2004) and Ga These reviews indicate that much behavioural finance uses the corpus of work that demonstrates biases in human judgment and decision making (Kahneman et al., 1982) to explain investor behaviour and market anomalies. There is, however, increasing recognition that we need to move towards a theoretical framework that accounts not just for the circumstances that produce inefficient information processing but also for those that produce efficient information processing (Shefrin, 2005). There have been other developments too. Tversky and Kahneman (1974) argued that cognitive biases occur because people use heuristics (mental rules of thumb). They use them because they do not have the cognitive resources to carry out the procedures necessary to make normative decisions. Although Tversky and Kahneman (1974, p. 1131) argued that these heuristics are economical and usually effective, they pointed out that their use leads to biases under certain circumstances. They focused on those circumstances because doing so allowed them to cast light on the nature of the heuristics that produce them in much the same way that vision scientists study visual illusions in their attempts to understand the visual system. However, this strategy resulted in many people gaining the impression use of heuristics leads to irrational decisions. To counter this view, Gigerenzer et al. (1999) instigated a programme of research geared to demonstrating that heuristics often produce exceedingly good outcomes. They have demonstrated that, in out-of-sample tests, simple models that ignore some information or weight different types of information equally can outperform more complex models, such as those based on multiple regression. For example, selecting who will win a tennis match purely on the basis of choosing the player whose name is

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recognised is a strategy that outperforms the rankings produced by the Association of Tennis Professionals (Serwe and Frings, 2006; Scheibehenne and Broder, 2007). Similar findings have been reported in other fields, such as medicine (Gigerenzer user, 2005), policing (Snook et al., 2005) and marketing (Wu bben and and Kurzenha von Wangenheim, 2008). Within finance, simpler strategies have been found to be superior to more complex ones for selecting stocks (DeMiguel et al., 2007). More recently, Haldane (2012), Executive Director for Financial Stability at the Bank of England, has applied Gigerenzers approach to bank regulation. He has reported a number of analyses that demonstrate that bank regulators would be better able to predict bank failure by using much simpler models than they do at present. He argues that the current regulatory regime based on the Basel III Accords should be radically simplified if it is to increase its effectiveness: Modern finance is complex, perhaps too complex. Regulation of modern finance is complex, almost certainly too complex. That configuration spells trouble. As you do not fight fire with fire, you do not fight complexity with complexity. Because complexity generates uncertainty, not risk, it requires a regulatory response grounded in simplicity, not complexity (Haldane, 2012, p. 19). These examples demonstrate that behavioural finance can provide us with prescriptions as well as descriptions. 2. Experimental work in finance Experimentation is a mainstream methodology within psychology whereas it has been less common within finance. Here, we shall briefly outline some of issues that those working within finance initially studied non-experimentally but that have more recently been subject to experimental research. Researchers within finance have been aware of the potential importance of psychologists work on cognitive biases for some time. For example, the disposition effect (Shefrin and Statman, 1985) refers to the finding that investors are likely to sell shares that have increased in price but tend to keep those that have dropped in price. It is an anomaly that is consistent with what would be expected on the basis of prospect theory and with what we know about cognitive biases (e.g. the endowment effect). It has been demonstrated empirically by a number of researchers (e.g. Barberis et al., 2001; Coval and Shumway, 2005; Frazzini, 2006; Odean, 1998a). However, experiments related to this effect have been comparatively rare: Thaler and Johnson (1990) and Post et al. (2008) report two relevant experimental studies. Similarly, the implications of overconfidence for finance (e.g. frequent trading) have been investigated by a number of authors, including Odean (1998b, 1999), Gervais and Odean (2001), Daniel et al. (1998) and Bloomfield et al. (2003). However, few experiments have been conducted as direct tests of the financial effects of overconfidence: they include those carried out on stock market professionals by nkal (1994) and O nkal and Biais et al. (2005), Muradoglu (2002), Muradoglu and O Muradoglu (1994). In finance, judgment is often used to make forecasts from time series data. Its effectiveness can depend on forecasters beliefs about the presence of regime shifts in those data. Historically, those working in finance have examined size of errors in real forecasts but such studies did not permit researchers to examine the features of time series that make forecasting difficult. Experiments allow factors that affect both judgmental forecasting (De Bondt, 1993; Lawrence et al., 2006; Harvey and Reimers, 2012; Reimers and Harvey, 2011) and beliefs about regime change (Bloomfield and Hayes, 2002; Speekenbrink et al., 2012) to be studied systematically.

Failure to ignore sunk costs is an issue in finance: for instance, it is likely to have a role in producing the disposition effect. The phenomenon has been demonstrated experimentally in both children (Krouse, 1986; Webley and Plaisier, 1998) and adults (Arkes and Blumer, 1985). It has even been possible to investigate whether in non-human animals (in the context of which it is known as the Concorde fallacy): Dawkins and Carlisle (1976) concluded that animals suffer from the fallacy whereas other researchers have failed to find any evidence that they are susceptible to it (Dawkins and Brockman, 1980; Maestripieri and Alleva, 1991). These latter results led Arkes and Ayton (1999) to question whether humans behave less rationally than lower animals. Within finance, there is a concern about the validity of studies that have used participants drawn from the general population. Conclusions drawn from such studies may need some modification if they are to be applied to investors, either individual or corporate. Thus, Burns (1985) argues that finance professionals behaviour may differ from non-professionals behaviour due to training, reputation, etc. Similarly, Haigh and List (2005, p. 524) argue that Locke and Mann (2000) take the argument a step further by suggesting that any research that ignores the use of professional traders is likely to be received passively because ordinary individuals are unlikely to have any substantial impact on market price since they are too far removed from the price discovery process. Similar views have been expressed by Christensen-Szalanski and Beach (1984) and Frederick and Libby (1986). Of course, the similarity in the behaviour of finance professionals and lay people is actually an issue that needs to be addressed via empirical studies. What have such studies shown? In one of the first experimental papers to be published in the Journal of Finance, Haigh and List (2005) reported an experiment using 54 professional futures and options pit traders from the Chicago board of trade and showed that traders nkal and Muradoglu (1994, 1995, exhibited more myopic risk aversion than students. O 1996) conducted a series of experiments comparing finance professionals and novices in a task requiring probabilistic forecasting of stock prices. They found that finance professionals were more over confident than novices but that they could reduce this bias if they were given feedback. Thus, at least in certain financial tasks, differences between professionals and lay people occur. So the research shows that, at least in some financial tasks, conclusions drawn from studies of lay people do need to be modified if they are to be applied to professionals. However, they need to be modified in a surprising direction: biases have been found to be larger not smaller in professionals. Clearly, experience does not always produce expertise. This issue need not concern us when the finance tasks of interest are ones that are normally carried out by lay people. Thus, for example, two of the papers in the current issue are concerned with credit markets: they examine factors that influencing the use of credit by lay people. Here sampling participants from the general population is clearly the most appropriate approach. Furthermore, lay people now have increasing access to stock markets via the internet. The distinction between individual investors who are professional and those who are not is much less clear than it has been in the past. Even in stock investment tasks, such as that reported in third paper in this special issue, non-professional participants validly represent a section of the general population that invests in stock markets. More generally, experimenters are increasingly adopting web-based experimentation (e.g. Lo and Harvey, 2012; Lo et al., 2012; Reimers and Harvey, 2011; Harvey and Reimers, 2012). Links to an experiment are posted in various forums.

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This allows participants to be drawn from a much broader demographic than that provided by local students. It is even possible to carry out studies on specific populations drawn from various countries by selecting particular forums on which to post the web link to the experiment. For example, studies reported by Lo and Harvey (2011) used this approach to show that availability of credit cards differentially affects purchasing behaviour of compulsive and non-compulsive shoppers in the UK and Taiwan. In this issue, we have two papers that use experimental methods. The first paper is rling, Martin Hedesstro m and Anders Biel written by Maria Andersson, Tommy Ga from the University of Gothenburg. They studied impact of the length of a time series on the predictions of stock prices and investment decisions. The effectiveness of judgment as a means of making forecasts from time series and as a basis for making decisions using those forecasts is a well-researched area (Harvey and Bolger, 1996; Lawrence et al., 2006). However, Andersson and colleagues were interested in it because of their concern about short termism in financial markets (Stiglitz, 1989). They define short termism as a preference for actions in the near term that have detrimental consequences in the long term. They argue that bonuses based on the performance over the last year or even over the last quarter are signs of short termism. In three experiments, they investigate the effect of longer evaluation intervals on financial decisions. In their first experiment, on students from the University of Gothenburg, they conducted a laboratory experiment that lasts about 30 minutes. Participants played the role of an investor employed by a company. They were presented with price series for nine shares over five, ten or 15 days. Trends in the price series were systematically varied. Participants were asked to make a prediction about the price before making a purchase decision for up to 100 shares. No significant effects of the length of the price series were observed either in predictions or in investments. In Experiment 2, the authors added graphs of the price information because it is known that visually displaying the data can make trends more salient. This time, they observed that the predictions based on the longer price series of ten to 15 data points yielded smaller prediction errors but there was no impact on investment decisions. Finally, in Experiment 3, the authors added a condition intended to reduce participants information processing load: in this condition, each of five points represented aggregated data over three days, thereby lowering the number of data points that had to be processed. Price prediction errors were smaller in this condition than in conditions in which either five or 15 non-aggregated points were presented and risk taking for investments was closer to optimal. Their paper is important for its policy implications in the context of the current debate on bonuses. People are in general myopic. Graphs may counteract the myopic tendency to a certain extent by defocusing the attention from the most recent information. When the number of data points is reduced and averages are presented to reduce local variation, both prediction and investment performance are improved. Thus, to distract investors from myopic decisions, aggregation over time is a useful strategy. Our second paper is written by Sandie McHugh and Rob Ranyard from the University of Bolton. They examined the effects of information about the long-term financial consequences of different types of loans on credit repayment decisions. They conducted two experiments with a random sample of 2,000 people from a high street banks database of personal account customers. They processed 242 replies for the

paper that they present here. Two credit repayment scenarios, one with a credit card balance of 1,500 and one involving re-mortgage of a property loan of 40,000, were devised. In these scenarios, participants selected a monthly payment level when given either no additional information, total cost information, loan duration information, or both total cost and loan duration information. Controlling for demographic information, the authors showed that provision of additional information produced higher repayment levels. In their second experiment, McHugh and Ranyard again examined the effects of provision of information about the long-term consequences of repayment decisions. However, in this experiment, which was conducted just after the 2008 financial crisis, they used a wider variety of credit repayment scenarios. They also added questions asking participants to estimate the likelihood that redundancy or illness would lead to repayment difficulties, to assess levels of worry this likelihood would produce, and to assess their levels of worry arising from the possibility of future rises in the cost of living. Higher estimates of the likelihood of personal circumstances leading to repayment difficulties and worry about future increases in the cost of living reduced repayment levels. In contrast, higher levels of education and worry about personal circumstances causing repayment difficulties raised repayment levels. The policy implications of the paper are important for retail banks. If they provided information on the cost and duration of debt repayments, they could speed up the repayment of loans, credit cards debts or mortgages. Selecting a lower payment plan is associated with worry about a change in personal circumstances causing repayment difficulties. Maybe lower repayment levels can be used as a means of credit risk management and be associated with taking payment protection insurance. 3. Use of surveys in finance Use of surveys in finance does not have a long history. In one relatively early study, Muradoglu (1989) surveyed about 500 stock investors in Turkey. At the time, there was much discussion in the country about the possibility of privatisation promoting demand among workers and about the possible effects of privatisation of companies on inhabitants in the neighbourhoods in which they were located. The typical stockholder is from the upper social class [y] Stock demand increases as education, income, savings and wealth increases (p. 167). Some of the findings have since been confirmed by the literature on home bias: [y] those investors who have personal and business relations with the management of the companies invest more in those companies because they feel confident in their action (p. 169) and by research on mental accounting: Turkish investors do not sell the stocks when the price is falling but they do not hesitate to sell them when the price is rising. They do not want to realise losses due to price movements. They can internalise losses only in the case of catastrophic situations (p. 171). Yet others have been supported by work on corporate governance: [y] investors prefer to buy the stocks of companies that are owned by a well-known group or individual (p. 173). Among the many recommendations was the suggestion that Further research may [y] be conducted by savings surveys just like the consumer surveys (p. 179). Nowadays, such surveys are carried out in much of the world, with high quality data available from the USA, the UK, and Scandinavia and other European countries. These include household level data on consumption and savings and debt. Mostly, it is economists who work in this area. However, as the third paper in this issue

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demonstrates, financial survey research includes an agenda that can be addressed by those working in behavioural finance. This paper by Stefano Cosma and Francesco Pattarin focuses on the role of attitudes in the use of consumer credit. They report a survey of 2,000 Italian households that was conducted in 2009. They distinguish consumer credit users from non-users. Importantly, their definition of consumer credit refers to institutional credit involving a request by a household that the banker considers solvent. This is contrasted with consumer debt which refers to debts that arise when someone does not fulfil their repayment obligations against their intentions and those of their creditor. The survey covered households in both the north and south of Italy and included different household sizes and different income earners in each household. Age, education and gender of credit users and non-users were reasonably well balanced. The questionnaire collected information about psychological characteristics as well as details of cognitive, emotional and behavioural attitudes towards consumer credits. First, Cosma and Pattarin show that cognitive and behavioural components of attitudes towards consumer credit differentiate credit users and non-users. These results were robust to the needs of the household. Second, they show that, as credit users attitude towards credit becomes more positive, they are more likely to finance consumption with credit cards or point-of-sale lending than by using personal bank credit or salary loans. In contrast, as the attitude of non-users becomes more favourable towards credit, they increasingly prefer point-of-sale lending to credit cards. Finally, Cosma and Pattarin show that the probability of taking on debt increases as the attitude towards debt becomes more favourable. The probability of using credit cards also increases as the number of income earners in the household increases and when there are strong expectations that income will rise. The paper is important in showing that, among the many determinants of credit use, attitude plays a significant role. The cognitive component which determines the individuals decision-making framework is crucial. The psychological profile of the borrower is an important factor in consumer credit decisions. 4. Why is work in behavioural finance important for finance? Behavioural finance is used to make recommendations to finance professionals about how to change their behaviour or how to communicate with their clients. Kahneman and Riepes (1998) list of recommendations includes the following:
. . . .

keep track of instances of your overconfidence; communicate realistic odds of success to your clients; resist the natural urge to be optimistic; ask yourself whether you have real reasons to believe that you know more than the market; make sure the frame chosen has relevance for the client; and assess how risk averse your client is.

. .

Further suggestions to financial advisors on how to take findings from behavioural finance into account have recently been outlined by Benartzi (2011). As we have seen, simple (fast-and-frugal) heuristics can provide an effective means of making complex decisions (Gigerenzer et al., 1999). We mentioned Haldanes (2012) application of them to the problem of bank regulation above. They can be useful in

others areas of finance as well, such as in the expectation formation processes underlying selection of the contents of portfolio. Thus, for example, Muradoglu et al. (2005) examined the effectiveness of an expectation formation process heuristically based on the subjective forecasts of finance professionals. The portfolio performance of subjective forecasts was superior to that of standard time series modelling. More generally, Ricciardi and Simon (2000) have argued that behavioural finance enables those who invest in stock and mutual funds to avoid common mental mistakes and errors and develop effective investment strategies. Others have argued that knowledge of behavioural finance should enable investors to become aware of how potential biases can affect investment their decisions and thereby to avoid such errors. This, in turn, should act to promote the efficiency of the market and so limit the need for regulation and improve information dissemination (Daniel et al., 2002). Similarly, awareness of findings in behavioural finance may lead to a change in working practices that improve performance: for example, use of feedback and a change in the way information is presented can improve forecasting performance (Harvey and Bolger, nkal and Muradoglu, 1995, 1996). 1996; O A common objection is that incorporating behavioural data into theories of finance would produce results that would be too complex to be useful in practice. Thus, Bloomfield (2006) has argued: No behavioural alternative will ever rival the parsimony and power of traditional efficient markets theory, because, psychological forces are too complex (p. 11). Even Thaler (2000, p. 140) has seen this as a problem: One reason economics did not start this way is that behavioural models are harder than traditional models. We have two responses to this objection. First, during the early development of traditional economic theory, the processes involved were seen as too complex to allow them to be described formally. Thus, when he wrote the Wealth of Nations, Smith (1776/1976) had to describe those processes in terms of an invisible hand; he could not describe them formally in the way we do today. The invisible hand was a metaphor that he used to communicate his view of an economic reality in which people act in their own self-interest but in which the market has the ability to correct itself without intervention. It was not until the late nineteenth century that Walras (1874/1954) modelled these economic processes in a rigorous manner and not until the mid-twentieth century that the law that he identified was proved formally. Behavioural finance is still in its early days: the path along which it develops may result in it becoming a more rigorous discipline. Second, we acknowledge that psychological processes are highly complex and those involved in the social cognition underlying financial behaviour especially so. Neuroeconomics and social neuroscience are still in their infancy. However, as we have seen, responses to complexity need not themselves be complex: in fact, they are more likely stebro and Elhedhli, 2006; Gigerenzer et al., 1999; to be effective if they are simple (A Haldane, 2012; Holte, 1993). The problem is in identifying the simple solutions that are appropriate for dealing with complex problems. Succeeding in this is still likely to require the development of a more rigorous approach. Finance has always borrowed methodologies from other disciplines. Methods developed in mathematics, physics and economics are now standard in finance. Methods developed in psychology have been imported more slowly. There are probably a number of reasons for this. For example, experiments are difficult and costly to conduct with investors and market professionals because their participation in experiments requires funds that exceed those available under standard finance

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academic research budgets. Nevertheless, although progress has been slow, work has been done and more will be done. The primary input to behavioural finance has been from experimental psychology. Methods developed within sociology such as surveys, interviews, participant observation, focus groups have not had the same degree of influence. Typically, these methods are even more expensive than experimental ones and so costs of using them may be one reason for their lack of impact. However, it is also possible that the training of finance academics leads them to prefer methodologies that permit greater control and a clearer causal interpretation. Nevertheless, interdisciplinary research is becoming more widespread and it is likely that greater collaboration between finance and sociology will develop in the future. Academics often cross disciplinary boundaries. They may simply borrow a single idea or concept from another discipline. They may work with those from another discipline but with only limited integration between disciplines taking place. Both of these are examples of multidisciplinary research (Klein, 1990). However, in true interdisciplinary research, disciplines or research methods are integrated into a new field of study (Mitchell, 1995). Behavioural finance may have started as a multidisciplinary endeavour but it is now an interdisciplinary field with its own learned societies, journals and conferences. However, it is still developing and continues to borrow methods and ideas from other disciplines. This bodes well for its future.
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